When dealing with a smaller company, typically companies doing under 5M yearly in revenue, the starting point to getting a valuation is to calculate SELLERS DISCRETIONARY EARNINGS.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit,  Seller’s Discretionary Income, Recast Earnings, or Seller’s Discretionary Cash Flow.  We’ll stick with the more commonly used, Seller’s Discretionary Earnings (SDE).

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use Earnings before interest, taxes, and amortization (EBITDA).

SDE vs EBITDA

SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, personal cell phone use, non-required subscriptions/membership, etc…. To qualify as discretionary, each expense must meet all three of these criteria:

1. Benefit the owner(s)
2. Not benefit the business or its employees
3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Often this list of ‘adjustments’ needs to be reviewed in detail and debated in the Due Diligence process.  Banks may not accept and of these adjustments which may effect a buyers borrowing position.  In an ideal world, seller stops all these expenditures in the year before a sale.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are typically part of the regular operations. Some examples are; storm repair damage after an act of nature, uncommon bad debt, asset sales, theft or vandalism repair, emergency repair costs, unusual staffing issues, or litigation costs.  One-time expenses may also scrutinized and debated bt the buyer, who will ask,”did that event really only happen once? Or is it likely to occur again?

How to Handle this Process

In M&A transactions buyers are concerned about risk and what they are not being told.  The best way to have a smooth closing is to eliminate and doubt/questions at the start of the process, and to have clean financial records.